Having soared over 25% off the briefly single-digit price levels thanks to well-chosen rumor headlines of an “imminent settlement”, news and facts on Friday started to eat away at that confidence…

And now, as Bloomberg reports, Deutsche Bank’s Chief Executive Officer John Cryan failed to reach an agreement with the U.S. Justice Department to resolve a years-long investigation into its mortgage-bond dealings during a meeting in Washington Friday, Germany’s Bild newspaper reported.

The meeting was meant to negotiate the multi-billion-dollar settlement the bank will have to pay to resolve alleged misconduct arising from its dealings in residential-mortgage backed securities that led to the 2008 financial crisis, according to a Bild am Sonntag report.

The German lender is still considering seeking damages against Anshu Jain and Josef Ackermann, who are both former CEOs of the bank, the newspaper reported. Bild said the bank froze part of the millions in bonus payments to Jain and other former top managers.

A Deutsche Bank spokeswoman declined to comment to Bild about the outcome of Cryan’s Friday discussion or about clawing back former executives’ compensation. Mark Abueg, a Justice Department spokesman, declined to comment.

Cryan, a Briton who speaks fluent German, has sought for the last three weeks to reassure investors that Deutsche Bank can weather the formidable obstacles to its financial health. His arsenal of strawmen include: denials of bailouts, blaming speculators, rumors of informal capital raising talks with Wall Street firms, rumors of capital injections from Germany’s blue-chip corporations, rumors (denied) of Qatari sovereign wealth fund investments, and the sale of key assets and elimination of thousands of jobs.

So what happens next?

Three things:

1) The “settlement-imminent”-driven 25% short-squeeze in stocks – completely decoupled from credit market’s less optimistic perspective – is going to end badly…

Some have wondered why the need to sell new paper at such a wide concession: after all as we reported before, DB has no current liquidity constraints courtesy of substantial ECB generosity, which backstop DB’s existing liquidity reserves of just over €200 billion.

3) A “bail-in” is more likely than a ‘bailout’, and as we detailed earlier, and here’s how it can be done…Jonathan Rochford, PM of Australian hedge fund Narrow Road Capital, explains that despite all the recent confidence-building rhetoric and posturing, Deutsche Bank will need a bail-in. In the following analysis he explains how it would (and should) be done.

Following the confirmation that hedge funds have started to reduce their capital and trading with Deutsche Bank its position is now perilous. It is correct to say that Deutsche Bank doesn’t have a liquidity crisis and that even if it did the Bundesbank could provide it with unlimited liquidity. But liquidity alone doesn’t guarantee a bank can continue to operate in the long term, solvency and profitability are essential as well. Deutsche Bank is at best borderline for both solvency and profitability with little prospect of either improving materially in the medium term. Deutsche Bank needs to substantially restructure its business activities and balance sheet, both of those will take time and capital neither of which Deutsche Bank has.

Insufficient Capital

Unlike other global banks Deutsche Bank has failed to adequately lift its capital levels since the collapse of Lehman Brothers eight years ago. It has been allowed to remain undercapitalised due to weak European regulators, which are fighting against global efforts to have all banks increase capital levels. Whilst German and Italian regulators are fighting for lower capital levels and avoiding dealing with their problem banks Switzerland and the US are implementing much higher capital levels, particularly for the largest banks.

On Deutsche Bank’s preferred measure, risk weighted assets, it sits behind most of its peers. That’s after it has gone through a capital optimisation exercise which reduced risk weighted assets without reducing their balance sheet by the same proportion. On the more rigorous leverage ratio shown below, Deutsche Bank is dead last at less than half of its peer group average. When Europe’s most systemically important bank is the most poorly capitalised of its peer group that is a major problem that needs to be corrected as soon as possible.

Conclusion

Deutsche Bank’s position is currently marginal as it is woefully undercapitalised and has no clear prospect of becoming meaningfully profitable. As the world’s largest derivative trader and Europe’s most systemically important bank this is untenable. Deutsche Bank is three times larger than Lehman Brothers, making the possibility of an unexpected and uncoordinated failure completely unacceptable. Deutsche Bank needs substantial time and capital to execute a turnaround, neither of which it now has. It does not have the profitability to grow its capital base quickly or to support a capital raising of the size it needs. Deutsche Bank needs either a bail-in or a bailout.

An orderly bail-in process would deliver Deutsche Bank the additional time and capital it needs. In the first instance, the bank should be declared non-viable with all equity, additional tier 1 and subordinated debt written off. By converting 63.1% of long term senior debt to new equity the leverage ratio would increase to an unquestionably strong 9%. Based on recent peer comparisons, bailed-in senior debt holders would receive a recovery of at least 94% of their current position. Using an IPO model, where management develops and presents a new strategy to potential investors over a 2-3 month period, would allow the recipients of newly issued equity an orderly process to sell-down their equity. It also creates the possibility of a substantial recovery for subordinated debt, additional tier 1 and equity investors.

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If the Lehman playbook continues to play out as it has done – denials of any problems… blame speculators… unleash short-squeeze on heels of rumors of foreign sovereign wealth fund investments… and finally acceptance – this will not end well…

Perhaps it’s time once again to listen to DoubleLine’s Jeff Gundlach, whose advice was simple: don’t touch it. “I would just stay away. It’s un-analyzable,” Gundlach said about Deutsche Bank shares and debt. “It’s too binary.”